5 Mental Mistakes That Can Punish Your Portfolio

Jason Stipp: I'm Jason Stipp for Morningstar. Several of us have heard of the big behavioral pitfalls, such as recency bias or confirmation bias, but Morningstar's Christine Benz says there are several smaller hang-ups that can also take a toll on your portfolio. She is here with me today to explain.

Thanks for joining me, Christine.

Christine Benz: Jason, it's great to be here.

Stipp: You say that there are some smaller mental mistakes that we make that might sound very familiar to a lot of investors. The first one is, assuming that a complicated investment is better than a simple one?

Benz: Right. One thing I think about is that if someone has quite a straightforward portfolio--maybe some cash holdings, a bond fund and a stock fund--that probably gets them 97% of where they need to go in terms of constructing that portfolio, assuming that they have those allocations right.

But I think people say, oh my goodness, there is this huge investment industry; it can't really be that simple, can it? And that's why I think people often get sold on complicated, sometimes expensive products, that they don't really need, because they are not satisfied with settling for the simple portfolio.

A great recent example came up when we were doing our Portfolio Makeover Week. There was a person I was working with. She had assembled a portfolio, actually with the help of an advisor, that had about 10 or 12 different sector-specific U.S. funds. And in aggregate, when I X-rayed it, what I saw was sector exposure that in many cases was very close to the S&P 500's or a total market index. So, she really wasn't getting a lot of bang for her buck with all that complexity and some extra costs.

So, I think sometimes investors do have a tendency to be a little bit overwrought. They assume that simple isn't necessarily better when oftentimes it really is.

Stipp: Keep it simple, always good advice for investors.

Number two, Christine, somewhat perhaps related to number one, is the notion we have that we get what we pay for, which doesn't always ring true in investing?

Benz: When you think about how we navigate a really complex and confusing world, you often use rules of thumb to help you make sense and to help you make good decisions, and in general, you get what you pay for is a pretty good one. So you know that if you are paying more for a car, you're usually getting a better car. If you're buying a pair of shoes, if you're willing to pay up a little bit, the shoes may last you a little longer.

But, in fact, when it comes to investments, it's one area--it's really counterintuitive for people--where the exact opposite holds true. Generally speaking, paying less will get you a better long-term return, will help you compound your money better and faster over the years.

So, it's something that investors have a really difficult time--this is a big mistake we see again and again, where investors think, well, if this fund charges a little bit more, the manager has to be better, right? But when we look at our data on fund performance, that's definitely not right.

Stipp: With so much data competing for investors' attention, they may be likely to overlook the smaller numbers or what seem like small differences, but you say over the long term, that can really cost you?

Benz: That's right. So, expense ratios, again, here's another area where you see these small sort of innocuous-looking percentage differences. You think, what difference could it possibly make if I pay 1% for a fund versus paying 0.50%.

Well, actually when that money gets compounded and you are adding to it over the years, that can be a huge difference, but investors tend to blow off those small numbers because they look pretty unimportant.

The same holds true with inflation. I think a lot of investors think, well, what's the big deal with inflation, why does it make such a big deal when I'm doing retirement calculations? Well, it makes an enormous deal in terms of eroding your purchasing power.

So, you know, we've heard recently that a million dollars used to sound like a lot to retire on. These days, actually, it's not all that much. So, people need to factor in inflation when they're doing their retirement calculation.

The same goes with withdrawal rates. People look at maybe 4% as sort of the standard rate. Could it be that big a difference if I nudge it up to 6%? Yes, it actually does make a really big difference when it comes to the sustainability of that portfolio.

Stipp: The fourth mental mistake: Although we've seen that active management has lost some investor dollars over the years, there are still a few big name managers that seem almost indestructible. You say it's a mistake to think that they will always be on top of their game?

Benz: I think it's human nature maybe to kind of look for heroes wherever they might be; maybe call it the Sully Sullenberger phenomenon where we really want to believe that people can do great things. And I think people fall into this mental trap where they look at a manager who's had a great track record, they want to believe that that will continue, and unfortunately they invest with that manager only after he or she has amassed that really great track record.

There are a couple of big pitfalls associated with doing that. One is that oftentimes when you've had a great performance streak, that's when the valuations in the securities that a manager prefers are not looking all that great. So that's one issue.

Another issue is, if you look at funds, what you see is that sometimes managers who have performed really well start to have other things competing for their time. So, maybe they have to start running a new fund or maybe they're managing other managers or going on CNBC, or maybe they just start to believe their own hype and don't work as hard as they once did. Whatever it might be, managers rarely have an unbroken streak of great returns.

So, don't believe it. If you invest with an active manager, expect that there will be periods of underperformance, and plan to invest your dollars maybe when the manager is in a trough and the valuations in the portfolio are looking a little more attractive.

Stipp: Over the years--you mentioned CNBC there--investors have much more access to information. They can get it on 24-hour cable news; they can get it through the Internet. And you say thinking that that will always give you an edge is really not the right way to go about it?

Benz: I think oftentimes you see the media comingle economic data and market information. So investors think, well, if I plug into the economic data that will help me position my portfolio better.

The fact is you've got a huge investment industry that's positioned to try to stay ahead of the news flow, that's trying to invest ahead of the news flow, so by the time you read about it or see it on TV or wherever you're getting your news, it's already factored into security prices.

So, I think a much better guide, if you are looking to stay ahead in your portfolio, is really to let valuations be your guide as to what to do next. That doesn't mean that you have to rebalance on a regular basis, but it does mean that you should do it periodically, tip back on the securities that have performed really well in your portfolio, and add to those areas that have underperformed, and that way you can capitalize on the parts of the market that are potentially undervalued, and that's a better guide to market performance than the news flow.

Stipp: Success in investing so often involves avoiding the mistakes, both the big ones and sometimes the smaller ones. Thanks for helping us avoid some of those mental mistakes today.

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